Best Risk / Reward Income Investments, Part II: Canadian Energy Infrastructure Stocks

The Problem: Conflicted by Fear and Greed

In the current market, many income investors are feeling very conflicted.

They are afraid of buying into an overextended rally

They are also afraid of missing further gains and dividend yields while sitting in cash

In Part 1, we discussed the following Canadian Electric Power stocks: Atlantic Power (OTC:ATPWF), Great Lakes Hydro Inc Fund (OTC:GLHIF), Innergex Power Income Fund(OTC:INRGF), Maxquarie Power & Infrastructure (OTCPK:MCQPF), Northland Power Income Fund (OTCPK:NPIFF). Now we look at the best of the energy infrastructure sector

A Solution: Selected Canadian Energy Infrastructure Stocks for Steady, High Returns

As my regular readers know, I am not a believer in the current rally, yet I hear the pain of conservative income investors who seek yields that are not only safe, but high.

Reward/Risk Overview

Why Buy These Canadian Energy Infrastructure Stocks?

If you must go long, these Canadian Electric Power stocks are all weather stocks that you can feel safe buying even in this volatile market.

Safety: They sport some of the safest, most reliable dividends to be found, backed by steady revenue streams and sustainable payout ratios. While they can and do suffer

High yields that keep you ahead of taxes and inflation

Payment in Canadian dollars, providing a critical element of diversification out of the “Obamanable shrinking US dollar” for those with heavy USD exposure

Most are relatively green power producers that will benefit from government incentives

Thus when/if the markets pull back, you can afford to sit with these because they pay you very well while you hold them.

Why NOT to Buy Them

They are relatively low risk, but not without risk. Primary risks include

Overall market risk: Like most stocks, these will fall if the overall stock market pulls back, and there are plenty of reasons to suggest that it will. High valuations compared to earnings, a still deeply weakened US and world economy, continuing job losses that threaten whatever fragile recovery there is, a banking system still on life support, etc.

Low liquidity: These are thinly traded, and thus tend to drop harder than the overall market.

Currency Risk: If global markets retreat, the CAD tends to fall against the safe-haven currencies: the JPY, USD, and CHF. Thus those seeking diversification out of the USD would suffer additional losses in currency value in the event of another major stock market decline.

These risks are real. That said, however, we believe the CAD will appreciate further over the long term against the USD. Canada’s banking system largely avoided the subprime mess, sparing Canada the need to expand their money supply (which devalues the currency) on anything like the scale of the US. Also, Canada is the West’s largest source of energy, and supplies other key commodities.

The selections below are not ranked in order of preference. All make excellent investments that will pay you well in all but the most dire conditions, and have continued to pay (and in some cases raise) dividends throughout the current crisis, proving their reliability.

CANADIAN ENERGY INFRASTRUCTURE STOCKS – Our Top Recommendations for Income and Safety (click to enlarge)

NOTES

The main criteria for evaluating conservative income stocks are 1) coverage of the distribution with distributable cash flow 2) performance of the major business lines 3) access to credit 4) ability to grow

5) Management’s commitment to sustaining and growing the distribution.

The good news: ATGFF did well on the first three.

Payout ratio was steady at 93%, an acceptable level for a steady revenue business like this.

Continued their expansion program, including

1900 megawatts of renewable energy development. It also finalized a contract with NOVA Chemicals to support the expansion of its Harmattan co-stream project with a 20 year, fee based deal

Management plans for an over 20% increase in capital expenditures for 2009-10, which will be enhanced by recent successful debt and equity offerings, as well as reliable cash flows from the company’s infrastructure in gathering/processing, natural gas, liquids, and power generation.

Additional 8.9% cut in operating costs in Q2

Debt remains very reasonable at 36.1% of capital, below their 45% targeted level

The bad news: ATGFF management intends to reduce distributions from a current CAD$ 2.16 per share to between CAD $1.10-$1.40 (6.5%-8.5% vs. the current approximately 11%) per share when it converts to a corporation, likely around late 2010. It will maintain its current level until then. Their rationale is that it will use the saved capital to fund growth. That’s a disappointingly large cut, but still worthwhile with future growth potential. Given the magnitude of the cut, however, we prefer to wait and buy this one when/if it comes in to the recommended price, in order to bolster the yield.

Net operating income up 18% due to a doubling of earnings from its oil sands infrastructure, the result of the completion of the Horizon Pipeline system (other new projects in process)

Midstream & Marketing business suffered as a result of falling commodity prices, but that part of the business will get a boost in Q3 from the addition of the Cutback facility, a deal completed this summer.

Management plans to maintain the dividend through 2013-2014, possibly longer (it converts to a corporation in 2011)

Conclusion

In the coming installments of this series, we will present additional ideas for uniquely safe, high yields.

Disclosure and Disclaimer: The author has positions in the above mentioned instruments.

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